What is DeFi? The ultimate guide to decentralized finance

Decentralized finance is one of the biggest blockchain success stories in recent years. Developers building on platforms like Ethereum, Solana, Avalanche, Polkadot, and others have been designing the infrastructure of a new financial system without trusted intermediaries or exclusionist gatekeepers. The sector’s growth is typically measured by the amount of capital associated with the smart contract comprising its various protocols. With the total value locked within DeFi surpassing $50 billion in April 2021, it's clear that many are in favor of this more democratic, decentralized approach to finance.

In the following article, OKX Insights provides a complete breakdown on the rapidly expanding DeFi sub-industry:

• We begin by defining what we mean by DeFi before briefly looking at the sector’s history.

• Next, we turn our attention to the different DeFi ecosystems emerging on the various independent blockchain networks.

• While exploring the categories of DeFi protocols in existence today, we introduce some of the top DeFi coins and projects.

• We then consider blockchain oracles, impermanent loss, and liquidity mining — all concepts that often come up when discussing decentralized finance.

• Finally, to round off this ultimate guide to DeFi, we conclude by discussing the sector’s riskier side.

What is DeFi?

Decentralized finance refers to a category of blockchain-based protocols that attempt to provide open access to the kinds of services found in the traditional financial industry.

Built on permissionless networks like Ethereum, the applications that comprise the rapidly expanding DeFi sector enable their users to engage in a host of familiar financial activities — without reliance on trusted central authorities. These activities include:

• Lending and borrowing

• Saving

• Spot trading

• Margin trading

• Derivatives trading

• Insurance

In the decentralized applications that make up the DeFi sector, smart contracts — i.e., digital agreements written in code — replace the trusted intermediaries found in the traditional financial industry. When a smart contract’s predefined conditions are met, the code executes automatically. This settles the contract without human oversight.

A smart contract’s code is permanently recorded to the public blockchain on which it's deployed. This enables some of DeFi’s more revolutionary qualities, including:

• Permissionlessness: Anyone can interact with DeFi protocols without prior authorization.

• Trust minimization: Being open-source, there's no need to trust whoever wrote and deployed a DeFi application. With the code publicly viewable, users can verify the functioning of the application themselves.

• Composability: DeFi protocols can interact with one another, allowing functionality that's simply not possible within the “walled gardens” of traditional finance.

• Censorship resistance: No one can censor transactions that interact with DeFi applications.

• Immutability: Once deployed, it's economically unfeasible to amend the code of a DeFi protocol. Users are sure that the same application will always behave in the same way.

• Low cost: Trusted intermediaries typically charge substantial fees for the services they provide. In DeFi, the protocols themselves serve the same role as many of these expensive middlemen.

• Transparency: All transactions interacting with DeFi protocols are viewable by anyone. Traditional finance, by contrast, is much less transparent and is routinely host to scandals that involve central authorities breaking the trust users place in them.

A brief history of DeFi

The history of decentralized finance begins with the launch of Bitcoin in 2009. Although not the first effort to create a purely digital currency, Bitcoin was the first viable system to enable value transfer without reliance on trusted intermediaries.

Bitcoin introduced the world to blockchain technology, but its foremost focus on security means the network isn't very flexible. Implementing proposed changes — even when widely supported — takes a long time. Such rigidity serves Bitcoin well in its assumed role as a store of value for the cryptocurrency industry, yet it makes the network less suited to supporting a DeFi ecosystem like those found on later blockchains.

Inspired by Bitcoin, Ethereum co-founder Vitalik Buterin put forward a more flexible system in 2013. Ethereum launched in 2015 and featured a more sophisticated programming language called Solidity. Described as a Turing-complete language, Solidity enables developers to write and deploy the smart contracts that form the decentralized applications hosted on the Ethereum network.

The greater flexibility of Ethereum quickly attracted a large community of developers who began building applications on the network. In 2017, many Ethereum developers sought to fund their work via a process known as an initial coin offering. Despite the questionable legality and dubious end goals of some ICOs, the speculative mania they encouraged generated the capital required for the most committed DeFi teams to continue working on projects throughout the subsequent bear market.

The launch of Uniswap and Synthetix in 2018 and 2019, respectively, introduced concepts that other dominant protocols in the sector would later adopt. Rather than attempting to match buyers with sellers to facilitate trades, Uniswap enabled trading via user capital pooled in the protocol’s smart contracts. These liquidity pools take the place of the order book model favored by centralized exchanges. Meanwhile, Synthetix was among the first to incentivize those providing liquidity to pools with rewards.

During 2018 and 2019, several other notable DeFi protocols went live. However, their adoption remained limited until the following year. In February 2020, the total value locked in all DeFi protocols surpassed $1 billion for the first time, although the then-emerging sector suffered heavy losses during the March 12, 2020, global market crash.

However, decentralized finance bounced back stronger than ever in the summer. Figures provided by data and analytics firm DeFi Pulse show the total value locked in DeFi again stood at just over $1 billion on June 1. By Sept. 2, it had hit an all-time high of $9.54 billion.

DeFi Pulse’s focus primarily on Ethereum means the data isn't reflective of the entire sector. However, it does clearly illustrate significant and growing interest in DeFi. Lending additional support to this notion is the increase in Uniswap trading volume from just $1 million to $1 billion over the same period.

A brief correction followed before slower growth returned toward the end of 2020. As the year closed, TVL across all DeFi stood at around $15.8 billion. Since then, interest in the sector has increased significantly. By April 6, 2021, DeFi Pulse reported a total of more than $52.19 billion locked in the DeFi ecosystems it covers.

DeFi ecosystems

Ethereum

As the first blockchain network to introduce a programming language capable of writing smart contracts, Ethereum has enjoyed a significant advantage with regard to decentralized finance. Being the first mover in the industry, many developers interested in exploring blockchain technology’s potential beyond Bitcoin began experimenting with the network shortly after its release.

According to data from Ethereum-focused software firm ConsenSys, as of the end of 2020, there were more than 130,000 developers registered with the popular Ethereum development suite Infura. This represents a growth of 87% over the previous year.

Reflecting the weight of development activity on Ethereum is the number of DeFi applications on different networks. As of April 2021, DeFi Prime reported a total of 251 DeFi projects. Of that number, 215 are based on Ethereum.

Again, the figures don't provide a complete picture, as they don't include data from several notable blockchains. However, other metrics support the notion that Ethereum remains the dominant network for decentralized finance. For example, data from analytics provider DeFi Review shows that, of the top 20 projects by TVL, 14 are on Ethereum.

“Ethereum killers”

Although ETH remains the second-ranked cryptocurrency by market cap, and the Ethereum network is the leader in terms of the DeFi sector it supports, there are several other blockchains with growing decentralized finance ecosystems of their own.

These smart contract-enabled chains are often labeled “Ethereum killers.” Their proponents believe such networks address Ethereum’s shortcomings. To them, it is only a matter of time before developers leave the original smart contract platform to build on a different blockchain.

Chief among Ethereum’s issues is its high transaction fees. The network’s structure is designed to promote maximum decentralization. This requires incentivizing as large a group of distributed and non-trusting transaction validators as possible.

To keep hardware demands low, the number of transactions that can fit in a single block is limited. However, Ethereum’s increasing utilization — primarily driven by DeFi itself — means that blocks are often completely full. Therefore, those wishing to transact must outbid other users when submitting transactions. These rising transaction fees currently price out many retail users looking to interact with Ethereum DApps.

The network’s ongoing upgrade to Ethereum 2.0 aims to address this issue. Yet, it remains unclear exactly when the higher performance system’s final rollout will be. In the meantime, with the cost to transact on Ethereum too high for many users, developers have started to look for cheaper alternatives.

These “Ethereum killers” often use consensus mechanisms that increase transaction processing speeds, layered designs that reduce competition for block space, alternate data storage methods, and other optimizations to ensure high performance. While these tweaks can create networks with significantly greater transaction throughput than Ethereum, they often sacrifice decentralization in the process.

The dominant non-Ethereum blockchains that support DeFi ecosystems today include:

• Polkadot: A smart contract-enabled blockchain that allows users to launch their own networks, known as parachains.

• Cardano: A peer-reviewed, proof-of-stake smart contract platform.

• TRON: A blockchain with a smaller group of delegated transaction validators to optimize for speed and low-cost transactions.

• Solana: A high-performance blockchain that introduces data storage, consensus mechanism, and transaction broadcasting innovations in an effort to serve a greater number of users.

• EOS: A delegated-proof-of-stake network focused on providing an enterprise-grade blockchain ecosystem.

• Cosmos: A network of independent blockchains running in parallel, enabling cross-chain compatibility.

• Avalanche: A blockchain network aiming to promote interoperability between chains.

Several of the above blockchains support the immediate deployment of Ethereum-native applications. The ease with which developers can move projects from the highly congested Ethereum to a more economically viable blockchain makes such solutions increasingly popular. For example, after finding success on Ethereum, the popular decentralized exchange SushiSwap was recently deployed on Avalanche.

Top DeFi tokens and protocols

Each decentralized finance protocol attempts to recreate one or more services found in the traditional financial industry. Below, we introduce some of the top DeFi tokens and projects from the major categories.

Lending and borrowing

Lending and borrowing are crucial to a financial system. In traditional finance, banks or other financial institutions facilitate lending with deposits from other users. Incentivizing lenders is the interest borrowers pay.

Lending and borrowing in decentralized finance work similarly. However, decentralized applications take the place of trusted intermediaries. Popular DeFi lending protocols include Aave and Compound.

Lenders supply capital to the money markets created by protocols and receive algorithmically determined interest payments. Meanwhile, when borrowing from a platform such as Compound, users must send collateral to a smart contract.

Typically, DeFi protocols demand over-collateralization — i.e., the backing of loaned funds with more capital than is borrowed — to protect systems from the significant price swings synonymous with digital assets. Should the user be unable to repay their debt for whatever reason, the collateral reduces the lender’s risk.

Exchanges

Another of the key pillars of the traditional financial system represented in DeFi is currency exchange. Decentralized exchanges allow users to trade one cryptocurrency for another without requiring a central authority to custody funds. There are two main models for DEX platforms:

• Automated market makers

• Order books

Order book DEXs match buyers with sellers to facilitate trades. On-chain order book DEXs — such as Bitshares — rely on networks of nodes to keep a consistent order history. This model involves many on-chain transactions and, therefore, significantly increases the demand for block space on the respective network.

Off-chain order book models — like that of the now-defunct EtherDelta — were created to address this. However, since a central authority oversees the order book, such implementations can't be described as fully decentralized.

The automated market maker model — as popularized by Uniswap — revolutionized the concept of decentralized exchanges. In AMM protocols, liquidity pools take the place of traditional order books. When a trader buys or sells a cryptocurrency at an AMM DEX, they contribute one of the assets of a trading pair to the pool while taking the other from it. Those providing the liquidity to the pool are rewarded with a share of the platform’s trading fees.

Other examples of DEXs based on the AMM model include SushiSwap and Bancor.

Derivatives

In finance, derivatives contracts are financial instruments that derive their value from an underlying asset’s price. Derivatives are contracts between two or more parties that set the terms under which one party must pay the others. Examples of derivatives include options, futures, and swaps.

Derivatives are often used to hedge risk. For example, a commodity producer may protect against possible price volatility by entering into a futures contract that sets a sale price at a specified date, regardless of the actual market price. Similarly, in the cryptocurrency industry, companies may hedge their exposure to highly volatile crypto assets using derivatives contracts.

Derivatives are also a common vehicle for speculation, as they allow traders to bet on price trends without holding the underlying asset. As such, contracts are often leveraged with borrowed funds. Leveraging a position increases both the potential risks and rewards.

Several notable derivatives platforms in the DeFi sector offer financial instruments without reliance on trusted intermediaries. Typically, they use combinations of liquidity pools, over-collateralization, the issuance of synthetic representations of assets, and other mechanisms to enable the creation of contracts without central authorities. Examples of DeFi protocols offering derivatives trading include Synthetix, Perpetual Protocol, dYdX, and Hegic.

Stablecoins

Given the immense volatility of cryptocurrencies, stablecoins are another vital part of the decentralized finance sector. Lending, borrowing, trading, and other financial activities are affected by the dramatic price movements of crypto assets — particularly when more than one asset is involved.

Stablecoins reduce the risks posed by volatility by introducing digital assets that are pegged to more consistently priced currencies. Originally created as a tool for traders to exit positions in BTC and other crypto assets into something more stable, stablecoins serve a similar purpose in DeFi.

There are three main categories of stablecoins today:

• Fiat-collateralized: Stablecoins like USDT and USDC that are issued by a central authority. Each token is backed by the equivalent amount of fiat currency held in a bank account.

• Crypto-collateralized: More decentralized stablecoin options — such as MakerDAO’s DAI — involve using crypto assets as collateral. Since the assets backing these stablecoins are often volatile, crypto-collateralized stablecoins usually require over-collateralization.

• Algorithmic: Algorithmic stablecoins — such as ESD and FRAX — attempt to maintain consistent prices by automatically adjusting their supply against changing demand. They represent a more decentralized option than fiat-collateralized stablecoins and more efficient capital use than crypto-collateralized stablecoins. However, with absolutely nothing backing them, elastic supply token prices are often more volatile than other stablecoin options.

Additional DeFi concepts

Oracles

Without external data feeds, smart contracts can only execute in response to data available on the blockchain on which they are deployed. Smart contracts become a lot more useful when they have access to data that isn't available on-chain. However, data sourcing for smart contracts that may hold millions of dollars is fraught with security and trust concerns.

Blockchain oracle services — like Chainlink — source non-blockchain data and deliver it to smart contracts in a trust-minimized fashion. Oracles are particularly important to the DeFi sector, as a great deal of activity requires reliable asset price data not available on-chain.

Liquidity mining and yield farming

Liquidity mining and yield farming are terms associated with DeFi that are often used interchangeably. While liquidity miners and yield farmers attempt to generate income through interactions with DApps, the latter is usually a more involved process.

Liquidity mining refers to the process of providing liquidity to protocols’ liquidity pools to receive a share of the trading fees as well as newly minted tokens from the DeFi protocol itself. Meanwhile, yield farming refers to the process of moving funds between DeFi applications to maximize the returns generated by liquidity mining. Yield farming may involve more sophisticated strategies to leverage returns from multiple protocols.

Both yield farming and liquidity mining became incredibly popular in 2020. The launch of Compound’s COMP token created one of the first opportunities for liquidity miners and served as a significant catalyst for the entire industry.

Impermanent loss

Related to the concept of liquidity mining is impermanent loss — which represents a genuine concern for liquidity providers looking to generate passive returns.

When using AMM DEXs like Uniswap, liquidity providers contribute multiple assets to a liquidity pool at a ratio determined by the asset's current market price. In exchange, they receive LP tokens, which enable them to withdraw the percentage of the pool they initially contributed to.

For example, if a liquidity provider contributed 10 ETH and 10,000 USDT into a pool of 50 ETH and 50,000 USDT when the ETH price was $1,000, they'd be entitled to 20% of the pool upon withdrawal.

When the price of one of the assets of the trading pair changes, the ratio of assets in the pool adjusts accordingly. Assuming all other variables remain constant, if the ETH price were to double to $2,000, the number of Ether in our example pool would drop to 35 ETH while the pooled USDT would increase to around 70,000. If the liquidity provider were to withdraw from the pool, they'd receive 20% of the new ETH and USDT figures. At an ETH price of $2,000, the 7 ETH and around 14,000 USDT received would be worth about $28,000.

Given that the trader started with a balance of 10 ETH and 10,000 USDT, with ETH at $2,000, they'd have profited more by not providing liquidity at all. Their 10 ETH would be worth $20,000. When added to their 10,000 USDT, their assets would have a total value of $30,000. The $2,000 difference between these examples is referred to as “impermanent loss,” as the loss only becomes permanent when the liquidity provider chooses to remove their funds from the pool.

DeFi risks

As a radically new sector in the still-young cryptocurrency industry, there are many opportunities to profit from decentralized finance. In fact, it was DeFi’s passive income-generating potential through yield-farming strategies that drove much of the sector’s recent growth. However, DeFi can also pose significant risks to users.

Some of the most pressing risks presented by DeFi include:

• Protocol risk: DeFi smart contracts often store large amounts of cryptocurrency. This creates a significant incentive to look for vulnerabilities in the code. Such vulnerabilities in poorly written code have been exploited numerous times already, often leaving the application's users out of pocket. Similarly, malicious actors can purposefully deploy dangerous code to scam novice DeFi users.

• Composability risk: The interconnectedness of DeFi applications means that potential exploits may only appear when multiple protocols are used at once.

• Rug pulls: Some smaller DeFi projects have performed what's known as a rug pull on their early adopters. This involves the developers of a project draining a liquidity pool to profit from users’ liquidity.

• Regulatory risk: The traditional financial industry is heavily regulated to protect investors and help prevent financial crimes, such as money laundering. By contrast, DeFi remains entirely unregulated. A harsh regulatory clampdown would surely hurt the still-nascent sub-industry.

• Centralization risk: Some DeFi ecosystems and applications are more centralized than others. For example, some protocols have built-in master keys and other features that allow developers significant control over the project. Such additions are intended to protect protocol users. However, they might also be used to shut a project down entirely with enough pressure from regulators.

• Volatility: Even the top DeFi tokens are often highly volatile. Unexpected price volatility may result in significant losses for DeFi users.

A bright future for DeFi

DeFi is one of the fastest-growing and most exciting sectors in the cryptocurrency industry. The use of smart contracts deployed on permissionless networks extends access to financial services to those typically excluded from them.

Although the sector is still in its infancy, major DeFi ecosystems have quickly absorbed more than $50 billion of capital. This growth looks set to continue, particularly as Ethereum transaction fees drive developers and users to alternative blockchains, such as Solana, EOS, Polkadot, and others.

Many of the major pillars of the traditional financial industry are already represented in DeFi. Decentralized lending, borrowing, trading, and insurance solutions are among those that have attracted significant user bases.

Yet, the industry is still very young and, as such, continues to present significant risks. Users of these cutting-edge protocols should be aware of the threats posed by vulnerabilities in the code of smart contracts themselves, alongside possible regulatory clampdowns, the ever-present volatility of crypto assets, and even risks created by a lack of decentralization.

That said, DeFi’s revolutionary potential makes it a sector that's full of opportunity. Armed with this ultimate guide to decentralized finance, you should now be better equipped to avoid the risks and learn more from the latest developments in this fascinating and expanding sub-industry.